UBS: Latest Credit Market Casualty

The Wall Street Journal has broken the story that UBS will announce that it is writing down its fixed income book as much as 4 billion Swiss Francs, or roughly $3.4 billion, which will result in losses of 600 to 700 million SFr for its third quarter.

Although this write-off is greater than those taken by other investment banks like Lehman and Morgan Stanley whose quarters end a month earlier, and thus aren’t exactly comparable, UBS may have company soon. As the Journal observed:

Among banks that haven’t yet reported, Merrill Lynch & Co. faces a possible third-quarter write-down of as much $4 billion to reflect losses on mortgage-related securities and buyout-financing commitments, a Wall Street analyst predicted last week.

Part of the Journal’s discussion, however, warrants a bit of further explanation:

The write-downs represent the first big stamp made by UBS’s new CEO, Marcel Rohner, who was named in July after the bank ousted his predecessor in the wake of the shutdown of its internal fund, Dillon Read Capital Management. Mr. Rohner said shortly after taking control of UBS that he would pursue a more conservative strategy, such as limiting growth of UBS’s investment bank. In setting its write-down, UBS is valuing its assets conservatively, people familiar with the matter said. A write-down would also let Mr. Rohner try to ring-fence problems that started before he took the helm.

According to a person familiar with the matter, Mr. Rohner now will personally oversee UBS’s investment-banking division in place of investment-banking CEO Huw Jenkins. The London-based Mr. Jenkins has overseen the division for the past two years, a period in which it grew aggressively, and also took on risks linked to the U.S. subprime-mortgage market at a time when those assets were already beginning to founder. As the damage from the division’s trading strategy began to unfold Mr. Jenkins in early August replaced the bank’s fixed-income chief, but its troubles mounted in the months that followed.

First, Marcel Rohner’s “ring fencing” means he has an incentive to recognize not just actual losses, but any likely losses. It’s in his interest to take one massive, comprehensive hit now, rather than have the Chinese water torture of continuing quarterly write-downs that would reflect badly on him. That means, to the extent that there is any uncertainty in how to mark positions, they will have taken a negative view.

This in turn implies their results are likely not to be comparable to those of other firms, who don’t have cause to get all the bad news out at once. In fact, other Wall Street firms are likely exploiting whatever valuation latitude they have to show a more flattering picture, particularly since some managers doubtless believe (or at least hope) this credit contraction will reverse itself soon.

Query whether the SEC will take an interest in the almost-certain valuation disparity between UBS and its peers.

Another issue is simply one of nomenclature. Because UBS is a universal bank, meaning it is both a commercial and an investment bank, its investment banking division comprises its entire securities operation. That’s a different use of terms than you find in a pure investment bank, whose investment banking operations consist of services sold to corporations, such as corporate finance, M&A, and so on. In these firms, the various trading operations, such as fixed income and equities, are housed in separate units. Thus, the statement “the damage from the [investement banking] divisions’s trading strategy” would make no sense at, say, a Goldman. They don’t have trading operations in their investment banking division.

The story also characterizes UBS’s woes as a result of having expanded its investment banking operations too quickly when the problem appears to have been quite specific:

UBS’s fixed-income division suffered after the bank set up Dillon Read, the in-house hedge fund it started in June 2005, because the unit siphoned off many of the bond team’s best traders.

Losses from Dillon Read widened to 230 million Swiss francs in the second quarter from 150 million Swiss francs in the first quarter, UBS said. Shutting it down cost the bank $314 million in the second quarter to cover restructuring, severance payouts and write-downs of unused rental space for the traders.

The latest losses are, in part, a result of continued costs of writing off Dillon Read’s soured mortgage bets, but they are also a result of other securities held by the fixed-income division.

Whether or not UBS’s bond traders were decent traders (note that trading on a day-to-day basis and acting as a proprietary trader, which is more or less what hedge funds do, are two very different skills), they weren’t very successful at running a hedge fund. And it has now become evident that UBS didn’t have the bench depth in its fixed income unit to support a major exodus of talent. Leaving a major trading operation in unseasoned hands is a prescription for disaster.

The coverage in the Financial Times echoes the Journal’s concerns about earnings at other investment banks:

But in recent days, analysts have become more concerned about the prospects for some of the banks whose quarter ends in September. Deutsche Bank shares were hit last week amid concerns that it will take big writedowns. Analysts have also dramatically reduced their forecasts for Merrill Lynch with William Tanona at Goldman Sachs predicting it will have barely broken even because of multi-billion-dollar mark-to-market losses on leveraged loans and collateralised debt obligations.

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